The official closing is undoubtedly the most important trade of the day.
It determines stock and index returns. It is used for futures and options settlement, mutual fund cashflow, and exchange-traded fund (ETF) creation and redemption.
It is also used to determine the volatility of stocks, the tracking error of index funds, and the outperformance (or alpha) of portfolio managers.
In short – it’s important.
The close is the biggest trade of the day
Because the closing price is extremely important to so many traders, the close is also typically the largest single trade of the day.
As the data below shows, closings typically account for more than 10% of the entire day’s trading. In some countries, such as Japan and developed countries of Europe, it is much higher.
Chart 1: The official close is the biggest trade of the day
Because of this, investors and issuers care (a lot!) about closing. They prefer to keep it predictable and stable – reducing rather than adding to trading costs. This requires a “good” closer:
- Low volatility.
- Less impact on the market.
- High liquidity.
- Not subject to last minute shocks or orders.
- Become a price at which many investors can participate.
Given that closing is such a big trade – and such an important trade – the market structure around closing is especially important. it need:
- Attract both buyers and sellers.
- Respond to supply and demand.
- Match many different buyers and sellers.
- Formulate the efficient value (unbiased estimator).
- Be simple and understandable for participants.
One challenge is to balance the transparency needed to attract offsetting liquidity for these very large trades, while limiting information leakage that could cost large investors trades more.
As index funds rise, closing is becoming even more important
An important participant in the closing are index funds, which tend to have very low tracking error. A liquid and reliable closing makes the index investable and replicable. The data shows that index funds are on the rise, which is undoubtedly contributing to the increasing size of closings around the world.
However, as we explained here, indexers typically reflect only a fraction of close trading. The close is also made up of mutual fund cashflow, option hedging, and other trades that take advantage of the relatively low cost of liquidity (the close typically occurs when spreads and volatility have fallen the most). There are also certain closings around derivatives expirations and index rebalancing, where expirations are even more significant, resulting in an even higher percentage of average daily volume.
Chart 2: The official close is the biggest trade of the day
There are four main ways to close the market
In an attempt to optimize the closed market structure, there is almost continuous development and improvement of closed processes. But in general, there are four main ways to “turn off” the stock market. In order of sophistication and complexity:
1. Final Trade
It works exactly like it sounds. When the market stops trading for the day, whatever the last traded price was becomes the “official close”.
This is simple.
But this may mean that the closing is determined by a very small trade, making it almost impossible for the indexers to match the closing.
2. Weighted-average price (WAP)
An extension of using only the last trade is to use a collection of end-of-day trades where the price is weighted by the size or volume of each trade, resulting in a weighted-average price (WAP) that better reflects overall market activity during the closing period.
This means that the closing is determined by a larger proportion of liquidity and reduces any “congestion of activity” as everyone tries to make the last trade, but it is still almost impossible for the index to match the closing.
It is mostly used by smaller, less liquid markets – those without large index trackers.
3. Auction
Almost all markets begin with an auction that calculates an equilibrium price where supply and demand become clear. Many markets, especially in Europe, also use a separate (separate) auction to determine the close price.
The advantage of this is that it becomes easier for indexers to match closings – even for very large amounts. However, when the auction is unexpectedly unbalanced (there are too many buyers or sellers), constant prices can sometimes lead to dislocations (or price fluctuations), which can occur on large index trading days.
4. on off
In North America, a different version of the close auction has developed. Instead of starting to build the ledger for the auction after trading has stopped for the day, it accepts orders (and publishes imbalances) while trading continues.
This allows market makers to hedge for auctions with constant volume. This makes the disturbances (or price fluctuations) from constant prices to auctions much smaller. However, by definition, when tickers are still trading, much information about close imbalances leaks to other traders.
Chart 3: Four main ways to “turn off” the market
Most modern markets use auctions
If we look at closing mechanisms over time, we see that using the last traded price was most common just 30 years ago!
A lot has changed in 30 years. During the 1990s most markets moved from open markets to electronic ones, US markets adopted decimal prices, index funds and program trading were created, and volumes exploded.
So, it’s not really surprising that the way the market closes has also changed.
In the chart below, we start with data from an academic study. This suggests that by 2014, most markets were already using standalone auctions to aggregate large amounts of trades, mix them all together, and set the official closing price.
We have updated this data for a sample of recent years using a slightly different approach (grey box in the chart below for 2018 onwards, where we also separate out WAP and final trades).
We see that modernization trends are continuing. However, in the wider world, we also see some countries use weighted-average price auctions. We will highlight that they are used in smaller and less liquid markets and are also declining.
Chart 4: The market has evolved from “last trade” to using auctions for most expirations
Why don’t North American markets rely solely on auctions at expiration?
A significant difference between the European and North American markets can be seen in the chart below.
- When Asian and European markets are closed, other liquidity is available in other countries.
- At the end of North American trading, there is a period when no markets are open, making it difficult to determine the source of liquidity and the price.
This makes it much easier to hedge against unexpected imbalances that may arise in auctions in Europe and Asia than in the US market.
However, we should also highlight that US stock and futures markets continue to trade well after their official close at 4pm Eastern Time.
Chart 5: European markets mostly use auctions; North America uses on-close
The overlap with continuous trading and close auction book-build is designed to enable access to some end-of-day liquidity to hedge the close.
In the studies we have done, we see that the market reacts quickly to imbalance messages, which shares close auction book-builds. Prices rise (for buying imbalances) and fall (for selling imbalances) – in proportion to the size (line thickness) of the imbalance.
Chart 6: MOC volatility in the US is generally quite low due to closing trading
Some consider this information leakage harmful to those trying to execute at closing because it gives other traders a chance to make profits from trades in the closing book.
However, as the chart above shows, even for large imbalances, the overall impact or “leakage” from the imbalance announcement is less than 15 basis points. Furthermore, the difference between the last trade price (red or blue line) and the actual closing (parallel gray lines of equal thickness) is, on average, a fraction of that.
In short, on-close facilities bring additional liquidity to the close – at a significantly cheaper price (for liquidity) and at a smaller average profit.
Other Ways to Reduce Volatility
Issuers and investors generally lose when prices move off dramatically due to large trading. There are some interesting ways that different markets try to compensate for that usage:
- Order types that compensate only for imbalances: from market orders that trade only on the “opposite” side of the auction book imbalance, to limit orders that compensate for adverse price changes caused by imbalance selling (limit buy) or imbalance buying (limit sell).
- Extension Period: To focus more attention and liquidity on stocks that did not originally have an “orderly” closing.
- Random Off: Make it harder for traders to add or cancel large trades at the last minute, giving investors and arbitrageurs time to balance out excessive market influence.
Chart 7: Some closes use collars to prevent prices from rising “too far” at the close
Another important feature of the close is that it aggregates all orders into one book, which helps minimize the impact and ensures that all investors get the same price.
If the closing was segmented as live trading often is, there would be multiple clearing prices depending on where orders were placed. This is a problem for investors because they are the frontier of demand and supply.
This means that a market with more buyers ends at a higher price, while a market with more sellers ends at a lower price. This is resulting in investors, overall, receiving worse prices than consolidated books.
In continuous markets, these costs are small, because arbitrage can occur between locations.
Auction markets are instant. This leaves no time for hedging or sending new orders. As a result, market makers take on execution and positioning risks – and liquidity costs will increase.
Chart 8: Investors most likely to suffer losses from multiple closures
As markets change, so does the closing phase
The trends we see in Chart 4 are far from over. Even markets that have long adopted a specific type of close regularly re-adopt rules. For example:
- In 2016, the Hong Kong Exchange moved from a time-weighted-average price (WAP) style to an auction close, with a new volatility control mechanism.
- In 2019, Nasdaq delayed the cutoff for entering orders, but introduced late LOCs (limit orders that could be entered even later) as a way to reduce leakage and still compensate for unexpected price movements.
- In 2021, Toronto changed the way the Canadian market closes, making it more similar to the US model
Close has always been important for investors, academics and traders.
It has acquired a market structure in itself.
